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Michael R. Bryant, Ph.D. Systematic Trading: Benefits and Risks

 by Michael R. Bryant

 

 

 

Systematic trading refers to buying and selling financial instruments, such as stocks or forex, using a predefined trading strategy called a trading system. Most trading systems are coded in a so-called scripting language that allows them to be executed on a brokerís trading platform.  The alternative to systematic trading is called discretionary trading, in which the trader makes buy and sell decisions on a trade-by-trade basis. Itís often said that the job of a systematic trader is to follow his/her system, whereas the discretionary trader may alter his/her strategy depending on how the market evolves.

 

One of the most significant benefits of systematic trading is that it helps to remove emotional decision making from the trading process. When real money is at risk in the markets, the emotions of fear and greed can easily overwhelm rational decision making. This can be mitigated to a large extent by having a trading strategy that makes the decisions for you.

 

Another benefit is that most trading systems can be automated, which means the buy and sell orders can be automatically executed through your brokerís trading platform as the system runs during live trading. This results in faster execution of the trading orders and reduces the likelihood that a trade may be missed due to second-guessing or hesitation. Automated order execution also makes it possible to trade strategies with short time durations. For example, a trading system that runs on one minute bars of the E-mini S&P 500 futures might be difficult to execute manually but might work well if automated.

 

Because systematic trading strategies are typically written in a scripting or programming language, they can usually be tested on historical data. This ability to back-test a trading strategy is one of the biggest benefits of systematic trading. Back-testing tells you how well the strategy would have done in the past. While back-tested performance doesnít guarantee future results, it can be very helpful when evaluating potential strategies. The back-tested results can be used to eliminate strategies that either donít suit your trading style or are not likely to meet your performance goals.

 

Traders new to systematic trading often question whether the systematic approach can be profitable. They sometimes believe that only buy-and-hold investing is profitable in the long-term. The reality is that professional traders, such as hedge fund traders and so-called Commodity Trading Advisors (CTAs), have been trading their customersí money profitably for many years using trading systems. These professionals, whose trading records are audited, have demonstrated for decades that systematic trading can be profitable.

 

Despite the benefits of systematic trading, there are risks as well. The primary risk is selecting a trading system that is poorly designed. A trading system can be poorly designed for several reasons, including being over-fit to the market, being based on unrealistic assumptions, or using inadequate risk controls. If you choose to design your own system, you need to have knowledge of market trading as well as strategy building techniques. If you decide to purchase a system, the primary challenge is evaluating potential strategies and selecting the best one based on your trading preferences and performance goals.

 

Assuming youíve chosen a viable trading system, there are risks during live trading as well. These risks include technology-related risks and execution risks. Particularly for automated trading, the speed of your internet connection can be a factor in trade execution. Itís also necessary to know how your trading platform will respond if you lose connectivity. Will you be able to place an exit order over the phone if necessary, and will the system keep proper track of your positions when it comes back up? Another execution risk is slippage, which is the difference between the price at which a trading order is placed and the price at which the order is filled. The amount of slippage you get can depend on your broker and the brokerís platform, as well as the market and time frame. If you donít assume sufficient slippage when evaluating a strategy, you might find that the performance results during live trading are below your expectations.

 

Lastly, no trading system remains profitable forever. Even the best trading strategy can stop working if itís based on some characteristic of the market that changes. Sometimes, a small modification to the system, such as changing an input value, can restore its performance. However, even if the strategy is fundamentally sound, itís always prudent to track its performance and be prepared to stop trading it if it stops working.

 

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